What if the Fed Doesn’t Taper?

Any poll you care to look at produces a clear majority in favor of the proposition that the Federal Reserve will be reducing its monthly $85 billion program of bond buying later, probably by around $10-$15 billion dollars.

Now, we know this isn’t really monetary tightening. We know that the settings will remain extraordinarily accomodative. The Fed will still be pumping vast torrents of liquidity into the U.S. economy fully five years after Lehman Brothers sank, and Fed funds rates are going nowhere.

All the same, if Bernanke and Co. stick to the script markets have written for them tapering will still be a momentous event. The beginning of the end of the financial crisis, just perhaps (file that under ‘Hostages to Fortune, would you? Thanks).

But what if they don’t go? Despite the base case that they will, a lot of those polls produce a sizeable minority that thinks the Fed won’t taper at all. Nearly 20% of respondents in CitiFX’s version think the Fed won’t be cutting stimulus today. That doesn’t make it vanishingly unlikely.

And, if you look at the central bank’s dual mandates, inflation and employment, you might argue that they’ve got all the excuse they need not to jump yet. Alright, so the unemployment level has fallen nicely, but so has the participation rate, to lows not seen since the late 1970s. The headline figure, 7.3%, flatters the facts and the Open Market Committee knows this as well as anyone.

Then there’s inflation. The Consumer Price index rose 1.5% on the year in August, down from 2% in July. Hardly screams ‘start winding up stimulus now,’ does it?

So what if the Fed doesn’t jump? Well, apart from a tidy profit for nearly 20% of CitiFX’s survey demographic, we can probably expect equity to take it quite well. Alright so stocks have been extremely resilient in the face of the taper prognosis, but the link between equity and Fed stimulus is so strong that it’s very unlikely to have broken by the prospect of slightly unwound stimulus. The Nikkei might seem an obvious exception at this point, thanks to the nexus between stimulus, a weaker dollar and Japanese exporters’ profits, but even that might come around.

Bond markets would be delighted to retain the Fed in full force as backstop buyer, and might even look around at other central banks, less certain that they will be tightening policy anytime soon either, leaving only the poor old dollar up against it as markets take off bets that a proper end to stimulus is anything like close.

The big question of course, is how the markets would take a taper hiatus more broadly. After all, it could only be justified by ongoing worries about the ability of the U.S. economy to stand up without the Fed’s huge monetary crutches. In the past worries about the weakness of the U.S. economy have been soothed at least to some extent by the promise of Fed liquidity for as long as it takes.

If the Fed doesn’t taper, those who’ve been buying stocks around their current highs must hope that crutch is still sufficient.